Scanning for 'relatively safe' foreign banks
With the continuing crisis in the Eurozone putting a spotlight on bank risks, I used VectorVest to scan for the foreign banks that with the highest "Relative Safety" scores. Recall that VectorVest calculates Relative Safety (RT) based on its analysis of:
the consistency and predictability of a company's financial performance, debt to equity ratio, sales volume, business longevity, price volatility and other factors.
VectorVest ranks stocks in terms of Relative Safety on a scale from 0 to 2, with 2 being the highest (best) possible score. The highest scoring name among the foreign banks in its universe on Tuesday was Itau Unibanco Holding S.A. (ITUB), with an RT of 1.20.
Hedging the 6 foreign banks with the highest RT scores
The table below shows the costs of hedging ITUB and 3 other foreign banks with high Relative Safety scores against greater-than-20% declines over the next several months, using optimal puts. Two other high foreign banks with high Relative Safety scores are listed below as well; these were too expensive to hedge against greater-than-20% declines over the next several months. First, a reminder about what optimal puts are, and why I've used 20% as a decline threshold; then, a screen capture showing the current optimal puts to hedge one of the foreign banks listed below, ICICI Bank Ltd. (IBN).
About Optimal Puts
Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones.
In this context, "threshold" refers to the maximum decline you are willing to risk in the value of your position in a security. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position). I have used 20% thresholds for each of the securities below. Essentially, 20% is a large enough threshold that it reduces the cost of hedging, but not so large that it precludes a recovery.
The Optimal Puts For IBN
Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of IBN against a greater-than-20% drop between now and March, 16, 2012. A note about these optimal put options and their cost: to be conservative, Portfolio Armor calculated the cost based on the ask price of the optimal puts. In practice an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask.
Click to enlarge
Why There Were no Optimal Contracts for HDB or CIB
In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with HDFC Bank Limited (HDB) and Bancolombia S.A. (CIB). On Tuesday, the cost of protecting against a greater-than-20% decline in those stocks over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal contracts were found for them.
Hedging Costs as of Tuesday's close
The data in the table below are as of Tuesday's close. The stocks are listed in order of Relative Safety, with the foreign bank with the highest Relative Safety, Itau Unibanco Holding S.A., listed first. Relative Safety scores of the stocks in this table ranged from 1.20 for ITUB to 0.98 for Bancolombia, S.A..
Cost of Protection (as % of position value)
Itau Unibanco Holding S.A.
|(BBD)||Banco Bradesco, S.A.||6.17%*|
HDFC Bank Limited
No Optimal Contracts
|(IBN)||ICICI Bank Ltd.||6.05%*|
|(CIB)||Bancolombia, S.A.||No Optimal Contracts|
*Based on optimal puts expiring in March, 2012
**Based on optimal puts expiring in May 2012